Pricing Carbon in the U.S.: A Model-Based Analysis of Power Sector Only Approaches

In June 2010, as the prospects in the U.S. Senate for an economy-wide cap-and-trade bill dimmed, some proponents of climate policy began to push for an approach more limited in scope. One proposed way to limit the scope of the bill was to apply the cap-and-trade program only to the carbon dioxide (CO2) emissions from electricity generation. This paper uses an intertemporal computable general equilibrium (CGE) model of the world economy called G-Cubed to compare a power-sector-only climate policy with economy-wide measures that either place the same price on carbon or achieve the same cumulative emissions reduction as the program limited to the power sector.

We first model a power-sector-only scenario (the Core Scenario) that broadly represents the emissions reduction ambition of a proposal offered by Senator Bingaman in July 2010. We calculate a linearly declining series of emissions caps for U.S. electricity generation from 2012 to 2030 that fall to 17 percent below 2005 levels in 2020 and 42 percent below 2005 levels in 2030. We calculate the CO2 price path that rises at the real interest rate that achieves cumulative emissions equal to the sum of the caps. The price rises at the real interest rate to 2030 and is constant thereafter. We assume that all tax revenues are distributed lump sum back to U.S. households. We then model a second scenario (the Same Price Scenario) in which the carbon price from the first scenario is applied to all fossil CO2 emissions in the US economy, not just CO2 from the power sector. Comparing this with the Core Scenario shows the incremental emissions reductions and other effects of expanding the policy from the power sector to the entire economy. The third scenario (the Same Emissions Scenario) calculates the increasing CO2 price path that if applied to all fossil energy CO2 achieves the same cumulative reductions as the Core Scenario through 2030. Comparing it with the Core Scenario shows the consequences, for both carbon prices and other effects, of using a narrow rather than a broad-based policy. To isolate the effects of U.S. policy, we assume the U.S. alone adopts these climate policies, with no comparable efforts abroad.

As might be expected, the Core Scenario results in a carbon price in the power sector that is almost twice the economy-wide price that achieves the same cumulative emissions. In particular, the power-sector-only approach requires a price on CO2 that begins at $23 in 2012 and rises to $46 in 2030, whereas the economy-wide price begins at $13 in 2012 and rises to $25 in 2030. We find that a price on carbon only in the power-sector does not produce offsetting increases in emissions in other sectors. Rather, we find that carbon emissions outside the power sector fall slightly relative to baseline. This is because of the economic linkages between sectors and the consequences of higher electricity prices on overall economic activity. Global emissions leakage is negligible as the price of oil in other currencies changes little.

All three policies have modest (less than one percent) negative effects on employment in the first decade and little effect thereafter. The policies that price carbon in oil, the Same Price and Same Emissions scenarios, produce much more revenue than the Core scenario.

We find that GDP grows in all of the scenarios at a rate slightly below the reference average in the first decade, but then remains close to reference thereafter. The most environmentally effective policy, the Same Price scenario, also produces the largest short run negative effect on GDP growth and long run negative effect on investment and consumption levels.

We find that all three policy scenarios reduce investment in the capital-intensive energy sector, which lowers imports of durable goods and strengthens the U.S. terms of trade. Thus we find trade consequences of climate policy even in the power-sector-only scenario, which one might think would have relatively low effects on terms of trade given that the U.S. electricity sector uses mostly non-traded fuels. All of the policy scenarios produce an overall decrease in consumption and investment in the U.S. relative to baseline. For consumption, the positive effect from relatively lower price of imported goods is offset by the declines due to higher embodied energy prices.

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